329 Final Exam Combined Notes PDF

**Lecture 1** ============= **Topic: Course Introduction** ------------------------------ ### Key Terms Financial System: Transfer funds in the most efficient manner possible *Two types of financing* 1. **Indirect:** Fund suppliers (savers) financial intermediaries fund demanders (borrower...

**Lecture 1** ============= **Topic: Course Introduction** ------------------------------ ### Key Terms Financial System: Transfer funds in the most efficient manner possible *Two types of financing* 1. **Indirect:** Fund suppliers (savers) financial intermediaries fund demanders (borrowers) - Funds go in as deposits and are transformed into loans by financial intermediaries 2. **Direct:** Fund suppliers fund demanders *Types of financial intermediaries* 1. Banks 2. Insurance companies 3. Pension funds 4. Mutual funds *Buy side vs. sell side* - **Buy side** - Primary function: Invest capital - Institutions: Asset management, pension funds, hedge funds, PE - The largest financial institutions are asset managers - **Sell side** - Primary function: Sell services - Institutions: Banks, insurance companies *Financial institutions by size* - **Largest: Asset Managers** - Biggest players: BlackRock, Vanguard, Fidelity - **Second largest: Banks** - The four biggest banks in the world are in China - JP Morgan is the fourth largest globally - **Third largest: Insurance companies** - Biggest players: Japan, China, Germany - Largest player in Canada is Manulife - **Fourth largest: Pension Funds** - Biggest players: Japan, Norway, South Korea - Canada Pension ranks 7^th^ - **Small: Hedge funds** - They are lacking in relative size but they make up for it in quantity there are more hedge fund in the US than Burger Kings - **Small: Private equity firms** - Major players: US dominates Blackstone, Carlyle, KKR, TPG, Warburg - Canadian firm Brookfield is 20^th^ *Services Offered by Banks* - **Retail banking** - Clients: Individuals and businesses up to a certain size - Products: lending and deposit focused - **Commercial banking** - Clients: Businesses - Products: Lending, treasury, and cash management focused - **Asset/Wealth management** - Asset management: Mutual fund-type offerings - Wealth management: Needs of high-net worth individuals - **Corporate banking** - Clients: Large companies - Products: Global lending, treasury, and cash management - **Investment banking** - Clients: Large companies - Products: M&A, sales and trading, market research *The Organization of Investment Banks* - **Industry groups:** Energy, telecom, Healthcare, Retail...etc. - **Product groups:** M&A, restructuring, ECM, DCM **Lecture 2** ============= **Topic: Major Financial Markets** ---------------------------------- ### Money Markets *Characteristics* - Short-term tenure - Standardized securities - Good liquidity/marketability (secondary market) - Low default risk - Wholesale open-market transactions - Centralized safekeeping - Sold on discount basis *Formulas -- See Formula Sheet* - Bank discount yield - Bond equivalent yield - Repurchase agreements **Instruments** *Commercial Paper* - Type of short-term loan that businesses use to get quick cash - **Major investors:** Commercial banks, insurance companies, nonfinancial business firms, bank trust departments, pension funds - **Bank involvement:** Backup lines of credit, agents in issuance, hold notes in safekeeping - **Placement:** Directly through sales force of the borrowing firm and indirectly through dealers *Negotiable Certificates of Deposit* - Large time deposits - May be sold and traded before maturity - Issued at face value - Interest rates depend on the issuer's creditworthiness - Yields are higher than T-bills because of higher credit risk, lower marketability, and higher taxability *Banker's Acceptances* - Order to pay in the future - Direct liability of bank bank agrees to pay the seller at a future date buyer pays bank on maturity date - Discounted in market to reflect yield **Commercial Banks** *Bank Assets* - T-bills - Agency securities - Bankers' acceptances (from other banks) - Federal funds sold - Reverse repurchase agreements *Bank Liabilities* - Negotiables CDs - Commercial paper - Bankers' acceptances - Federal funds purchased - Repurchase agreements ### Bond Markets - The majority of capital markets are debt rather than equity - **Major issuers:** Corporations and governments - **Major investors:** Households and financial intermediaries - **Investor considerations:** Long-term horizon, safety, tax considerations, reinvestment risk, interest rate movements - Reinvestment rate risk: When lender owns a bond they receive interest payments that they reinvest. If interest rates drop, they will have to settle for a lower return on their reinvestment. **Bond Indenture** *Collateral* - Mortgage bonds real assets - Equipment trust certificates equipment - Collateral bonds financial assets - Debentures unsecured *Claim on Assets* - Senior debt: First priority (paid back first if company goes bankrupt) - Subordinated debt: Claim ranking of unsecured debentures below senior creditors *Provisions* - Sinking Fund Provision: Periodic retirement of a number of bonds - Company makes regular payments into a special account called a sinking fund - When debt matures, money in the sinking fund is used to pay off the debt - Call Provision: Gives issuer the right to retire bonds before maturity - Issuer calls bank the bond before its maturity by paying back the principal amount and interest owed (lender loses future interest payments) - May do this when interest rates drop so they can refinance at a lower cost *Convertible Bonds* - Bonds that cane be converted into common stock **Market for Corporate Bonds** *Public Sale* - Open to all interested buyers - Most secondary trading of corporate bonds occurs through dealers vs. exchanges volume of trading is low and there is a wide bid/ash differential in the market - The market can have a personality based on interest rates, credit quality, industry... can be hot or cold *Private placement* - Sold to a limited number of sophisticated buyers - When interest rates are high, private placements increase *Junk Bonds* - Low rated corporate bonds below investment grade - High risk firms found they could issue longer term, more flexible securities in the high-yield market rather than borrow from commercial banks - *Securitized Credit Instruments* - Packaging loans and selling claims to future cash flows of the loans - Returns derived from cash flows of the loans - Value of new securities exceeds vale of loan cash flows *STRIPs* - Separate trading of registered interest and principal - Each coupon and principal of a US T-bill is sold separately by a dealer - Each separated security is a ZCB - Investors value zero-coupon default risk-free securities and are willing to pay more for STRIPs than underlying bonds **Global Bond Markets** *Foreign Bonds* - Issued in a financial market of a nation by a foreign company in that country - **Yankee bond:** foreign firm issues a bond in the US - **Samurai bond:** foreign firm issues a bond in Japan - Foreign bonds must be denominated in the currency of the country of issue *Eurobonds* - Issued by an entity in one or more countries denominated in a currency other than the currency of the country where the bonds are issued ### Mortgages Markets - Largest of the long-term debt markets - Large portion is for single family mortgages - Mortgage loans are secured by the pledge of real property - **Issuers:** small family or business entities - Weak secondary market issued and held by lender - Highly regulated *Fixed Rate Mortgages* - Payments are amortized over time - Interest computed on declining balance - Property used as collateral for the loan *Adjustable Rate Mortgage* - Borrowers' cost vary with inflation and interest rate levels - Lenders shift interest rate risk to borrowers - Caps on rates limit interest rate risk to borrowers - Payment caps: limit the maximum amount the payment can go up - Interest rate caps: limit the size of the increase in the loan rate *Mortgage-Backed Securities* - One way to develop a secondary market for mortgages - Mortgage-pass through securities: bundle of mortgages sold as securities to investors when homeowners make payments, they pass through the bank and go to investors - Other MBS use pools of mortgages as collateral for debt securities - Usually insured and highly collateralized *Unintended Consequences* - Huge government liability for mortgages created by government insurance - Mortgage market competes with the corporate bond market ### Equity Markets *Global View* - **US:** Largest equity market cap in the world but it does not have the highest number of listed companies - **Asia:** The Asian capital markets are home to the most listed companies globally Asian markets are larger than Europe - Order: Asia \> EU \> China \> US \> Japan \> Latin America - Types of investors: Corporate, public sector, strategic, and institutional - Institutional dominates in the US while other investors are more prominent elsewhere - Ownership concentration: About 1/3 of listed companies have a single owner holding more than 50% equity capital in most markets outside of the US *IPOs* - In 2022, global IPO activity plummeted markets were affected by volatility and policies undertaken to combat inflation - **IPO issues to consider:** - Inflation and interest rates - Liquidity and market volatility - Regulatory changes - Geopolitics - ESG *Common Stock* - A preferred claim on earnings and assets - Vote with their shares to elect the members of the board of directors one vote per share - Cumulative voting: If you have 100 shares and there are three directors, you have 300 votes that you can use for one candidate or split between multiple favours smaller shareholders - Straight voting: If you have 100 shares and there are three directors, you get 100 votes that you can use for one candidate or split between them favours larger shareholders - A residual claim on income and assets risker than bonds and preferred shares - Return is derived from dividends and the appreciation of the stock's market value *Preferred Stock* - A preferred claim on earnings and assets - Dividends are paid out before common - Usually excluded from voting for board of directors *Convertible Securities* - **Convertible preferred stock:** convertible to common stock at a specific common price or number of shares - **Convertible bonds:** convertible to common stock at a specific common price or number of shares *Primary vs. Secondary Security Sales* - **Primary:** new issue issuer receives proceeds from the sale - **Secondary:** existing owner sells to another party issuing firm does not receive proceeds *Security Sales Facilitated by Investment Banks* - **Underwritten:** firm commitment on proceeds to the issuing firm the underwriter guarantees that the company will raise a certain amount of capital by purchasing all the securities at an agreed price (if all securities do not sell to the public, the bank will buy the rest) - Investment banker purchases the securities from the company at the bid price and then resells the securities to investors at the offer price (greater amount) - Offer -- bid price = underwriter's spread - Gross proceeds = offer price \* shares sold - Net proceeds for company = bid price \* shares sold -- other costs - **Best efforts:** no commitment company bears the risk if the full offering is not sold - **Negotiated:** issuing firm negotiates terms with investment banker - **Competitive bid:** issuer structures the offering and secures bid issuer opens the offering to multiple investment banks and gets them to bid on how they would price and underwrite the securities (bank with the best terms wins) *Public Offering* - Registered with the SEC and sale is made to the public - Red Herring: a preliminary version of the prospectus that does not include final pricing or number of securities used to gauge interest before setting final terms - Prospectus: required by law to give investors information they need includes final details like pricing and number of shares - Usually underpriced stock typically jumps in price on the first day of trading - Attracts investors - Mitigates risk for underwriters - Positive publicity (when price jumps) - Shelf registration: permits a corporation to register a quantity of securities with the SEC and sell them over a period of two years rather than all at once - Allows issuer to save time and money through a single registration - Securities can be brought to market with little notice flexibility in timing *Private Market Offerings* - More highly negotiated with fewer, sophisticated investors - Require due diligence from the lead investor - Valuations are typically lower - Private market demands more stringent protections *Stock Exchanges* - The NYSE is the largest US stock exchange - Historically: smaller companies would begin trading in NASDAQ and move to the NYSE - Now: NASDAQ is NYSE's primary competitor *Globalization of the Equity Markets* - **American Depository Receipts (ADRs)** - Enhance ability to invest in foreign stocks - Issued by American banks and represent a specific number of shares of a foreign company - Issued in the US and denominated in US dollars - **Global Depository Receipts (GDRs)** - Similar to ADRs but traded on international exchanges (outside of the US) - Pros of ADRs and GDRs: - **Investors:** Allow investors to diversify their portfolios while reducing transaction costs and risk - **Companies:** Enhances a visibility internationally and increases liquidity by attracting new investors ### Derivative Markets - The financial futures markets have grown in recent years because people are concerned with interest rate, exchange rate, and stock market risk - **Financial derivative securities:** securities that derive their value from changes in the value of other assets - Minimize exposure to interest rate, foreign exchange, and commodity price risks - The notional vale of derivatives is much larger than the actual cash exchanged *Spot Versus Forward Market* - **Spot market:** trading for immediate delivery that occurs at spot prices - **Forward market:** trading for futures that occurs at forward prices - **Forward contract:** An agreement to buy or sell a specific amount of an asset at a specific future date and price - Buyers take long positions and sellers take short positions buyer expects price to rise while seller expects it to fall - Seller delivers at the settlement date - Private agreement between two parties customized contracts - **Future contract:** An agreement to buy or sell an asset in the future - Standardized in terms of amounts, delivery dates, and commodity grades more liquid than forwards - Traded on exchanges - Delivery is seldom made buyers/sellers offset their positions before maturity - **Options:** right to buy or sell an underlying asset on or before a specified date at ta strike price - **Call option:** right to buy - **Put option:** right to sell - An American option can be exercised on or before the expiration date while an EU option can only be exercised on its expiration date - Covered option: writer owns the security involved in the contract or has limited risk with other contracts - Naked option: writer does not have provisions to limit risk - In the money: an option that would be profitable if exercised - Buyer pays writer a premium for the option - The value of options vary: - Directly with price volatility of the underlying asset - Directly with time to its expiration - Directly with the level of interest rates - **Swaps** - Agreements to exchange payment obligations - Amounts are conditional on changes in interest rate - Used to hedge interest rate risk - Viewed as a series of forwards *\ * **Lecture 3** ============= **Topic: Regulation, Bank Reserves, and Monetary Policy** --------------------------------------------------------- **Regulation** *Purposes of a Central Bank* - Supervise money supply and payment systems - Regulate other financial institutions - Lender of last resort *The 2007 and 2008 Financial Crisis* - New regulations are often driven by major financial crisis - The 2007-2008 financial crisis sparked an 18 month recession - Defaults on home mortgages, falling house prices, and shar increases in commodity prices let to the collapse of many if the US' largest financial institutions - Crisis had the potential to stop the flow of funds through the economy fearful investors kept cash idle caused dropping prices in markets, impaired bank capital, and threatened ability of large banks to fund deposit withdrawals - People felt that if large bank failed, they threatened the stability of the overall economy - The financial crisis catalyzed new regulatory powers for the US Federal Reserve the new regulations addressed the fact that the fed could not allow giant financial firms to fail because it could cause irreparable damage to the economy - **Emergency Economic Stabilization Act of 2008** - Bailout of the US financial system during the financial crisis - Provided \$700 billion through the Troubled Asset Relief Program (TARP) for the US treasury to acquired distressed assets from banks and to make capital injections into banks - Bail out was unpopular with the general public - Only about \$436 billion was spent to assist firms and treasury recovered most of it by 2014 - **Dodd Frank Financial regulatory Reform Act of 2010** - AKA Restoring American Financial Stability - Expanded the Fed's ability to manage systemic risk in the economy - Gave Fed the power to intervene in the business activities of large firms so it could better monitor and control systemic risk across the economy - Goal for Fed to take appropriate action before large firms could threaten the stability of the economy - Fed has the power to take over the regulation of a firm or even break up firms if there is a threat to the economy - **Too big to fail problem:** act reduced the possibility of tax payers having to bail out firms whose failure would threaten the overall economy - Stripped the Fed of its oversight of more than 5,000 small bank holding companies and banks with less than \$50 billion Fed only regulated large banks with assets greater than \$50 billion in line with larger responsibility of identifying and managing systemic risk - **Basel III** - Financial crisis revealed shortcoming in existing capital standards - New basel accords to increase capital and liquidity levels in banks goal of increasing financial system's ability to withstand shocks - Some banks were considered to be systematically risky Basel III was designed to improve regulation, supervision, and risk management - Minimum capital, leverage, and liquidity requirements to ensure large banks could survive another crisis **The Current Structure of the Fed** *Federal Reserve District Banks* - 12 Federal Reserve banks in different regions - Assist in clearing and processing checks - Issue federal reserve notes - Act as a depository for banks in their districts - Participate in making monetary policy *Member Banks* - All nationally chartered banks must be a member of the Fed - The Fed regulates large banks and bank holding companies with assets of more than \$50 billion *The Board of Governors* - Sets the nation's monetary policy - The chairperson of the board formulates and executes monetary policy - Independent of congress and the president - Governors are appointed by the president *The Federal Open Market Committee (FOMC)* - Consists of members of the Board of Governors plus presidents of federal reserve banks - Determines monetary policy monetary actions directly affect the reserve balances of depository institutions and ultimately the country's money supply and level of economic activity *The Federal Reserve Bank of New York* - Has special status among federal reserve district banks - It has a day-to-day responsibility of conducting monetary policy for the Federal Reserve System **Federal Reserve Independence** - Fed is not directly under the authority of congress or the president - The Board is appointed by but not answerable to the president - The Fed funds itself which means congress has not "power of the purse" - Free from political and bureaucratic pressures when it formulates and executes monetary policy - **Pro:** Allows the Fed to better manage national economy by taking short-run policy actions that may be politically unpopular but benefit the overall economy in the long run - Example: Inflation up central bank raises interest rates controversial in politics but necessary to slow rate of growth and dampen inflation - **Pro:** Fed can absorb some blame if the economy falters **The Fed's Balance Sheet** - Monetary policy actions lead to changes in the Fed's balance sheet and ultimately changes in the nation's money supply - The fed conducts monetary policy by changing the monetary base MB = currency in circulation plus total reserves - **Liabilities:** - Federal reserve notes: largest liability - Depository institution reserves: all deposits held at the Fed and vault cash - Treasury deposits - Deferred availability cash items: checks that have not yet been credited - Capital: money paid by banks to purchase stocks fed pays dividend on stock - **Assets:** - Loans - Government securities - Cash items in process of collection - Float: extension of credit from the fed to depository institutions **Monetary Policy** *The Fed Has Three Major Tools of Monetary Policy* - **Open Market Operations** - Fed directly changes money supply by buying or selling US government securities - **Buy**: credits new reserves to a special bank account when fed buy a bonds from a bank, it pays for the bonds by creating money and the funds are deposited into the bank's reserve account at the Fed banks have more reserves and a greater capacity to lend - **Expands money supply** - **Results in lower interest rates** - Sells: takes existing reserves back - **Decreases money supply** - **Results in higher interest rates** - Money supply changes immediately and dollar for dollar - **Discount Rate** - **Discount rate:** Rate at which financial institutions must pay to borrow reserve deposits from the Fed - **Discount window:** Allows banks to borrow money from the Fed when they need extra cash - When banks borrow from the discount window, it adds money to its reserves increase in money supply - When banks pay back the money they borrowed from the fed, it decreases their reserves decrease in money supply - The Fed controls how much banks borrow by changing the interest rate When the fed increases the discount rate, they want to lower the money supply - **Reserve Requirements** - The amount of funds financial institutions must hold at the Fed to back their deposits - Reserve requirements are a structural control and changes have dramatic effects - Lower reserve requirements = increase money supply - Increase reserve requirements = lower money supply - **Note: In 2020 all reserve requirement ratios were set to zero percent (no reserve requirements) more like Canada now** - New approach uses an ample reserve regime versus a limited reserve regime - Fed now influences the interest on reserves balance rate (IORB) to steer the market determined rate into target range - **IORB:** rate paid on funds banks hold in their reserve balance account at the Fed risk free investment option - Higher IORB banks are incentivized to hold reserves money supply decreases interest rates increase - Arbitrage ensures that the market rate does not fall below the IORB rate - **The IORB is the Fed's primary monetary tool but it can also use the overnight reserve repurchase agreement rate and the discount window rate** *Canada: Flexible Inflation Targeting* - Does not use reserve requirements to conduct monetary policy - But banks are still subject to capital requirements - Bank of Canada influences the overnight interest rate - **Overnight interest rate:** Rate at which major financial institutions lend and borrow money from each other on an overnight basis - **Pros** - Allows for more flexible monetary policy because the central bank can respond more quickly to changing economic conditions - Encourages banks to manage their liquidity more actively *Goals of US Monetary Policy* 1. Price stability a. Changes in prices of goods and services that money can buy are measured by the CPI b. Inverse relationship between price levels and the purchasing power of money c. High rates of inflation increase uncertainty which makes it difficult to plan for the future and make long-term investment decisions 2. Full employment: implies that every person of working age who wishes to work can find employment d. Frictional unemployment: portion of unemployment are in transition between jobs e. Structural unemployment: mismatch between skills levels and available jobs f. A certain amount of unemployment is acceptable as people transition from one job to another 3. Economic growth: Generated through increased productivity of labor and capital 4. Interest rate stability g. Large interest rate fluctuations introduce additional uncertainty into the economy and make it hard to plan for the future h. High interest rates inhibit spending 5. Stability of the financial system i. Disruptions in the financial system can inhibit the ability of financial markets to channel funds efficiently in the borrowing and lending markets slow economic growth j. Fed provides stability by acting as a lender of last resort 6. Stability of the foreign exchange markets k. Exchange rates determine the value of the dollar relative to foreign currencies l. Widely fluctuating exchange rates introduce uncertainty into the economy and make it harder to plan and make interest transactions *Three Channels of Transmission Process for Monetary Policy* - **Monetary policy affects the economy through three basic expenditure channels** - **Business investment in real assets** - The present values of future cash flows from real assets depend significantly on interest rates when rates fall, the present value of cash flow rises - Most capital expenditures are debt-financed so interest expense is material in profitability for businesses - Business spending tends to increase in response to lower interest rates - **Consumer spending for durable goods and housing** - A lot of consumer spending is on credit so it tends to vary directly with credit conditions - Falling interest rates tend to encourage spending - Consumers don't make financial decisions the way businesses do (businesses are mostly rational while consumers are partly rational and partly emotional) - **Net exports (exports -- imports)** - Interest rates affect exchange rates and trade - Falling interest rates tend to weaken country's currency domestic demand for imports drops and foreign demand for exports rises - Rising interest rates tend to strengthen country's currency domestic demand for imports rises and foreign demand for exports drops - **Interest rates also have an effect on the value of securities** - Lower interest rates increase the value of bonds higher PV of coupon and face value payments - Lower interest rates increase the value of stocks lower risk free rate leads to lower cost of equity which means higher PV of business's cash flows *The Financial Crisis in 2008* - The size of the subprime mortgage market was huge it grew because of a real estate boom where properties continued to increase in value - Credit standards were relaxed because of the government's core value that that homeownership is desirable - Securitized subprime mortgages were brought to market as mortgage-backed securities - Securitization: process of distributing risk by pooling individual mortgages together and issuing a security backed by the pool - Mortgage backed securities are debt instruments backed by a mortgage pool - Nearly half of home buyers purchased variable rate mortgages - The subprime lending market worked well until home prices began to decline and interest rates began to rise - Many homeowners were unable to keep up with their payments and financial institutions who owned the securities were forced to take huge write downs and write offs - A financial system ceases to function properly when adverse selection and moral hazard problems become significant - Results in financial institutions making fewer loans spending decreases cash flows become smaller economic activity contracts *Overview of factors that contributed to the financial crisis* 1. Deterioration in financial institutions' balance sheets a. **Deregulation:** increasing homeownership became a goal for presidents reduced regulations to make more money available for subprime borrowers and expand mortgage loans to low and moderate income households loans were high risk and banks who had significant holdings in these loans incurred large losses b. **Pricing credit risk:** when subprime mortgages were securitized and sold as mortgage-backed-securities, the securitized debt was rated AAA home prices had been increasing for a significant amount of time and rating agencies believed that a decline in home prices was unlikely AAA rating allowed MBS to be sold to banks and other financial institutions in the US 2. The bursting housing bubble: housing prices became overinflated due to excess demand Fed maintained low interest rates low interest rates and rising housing prices led to a large number of homeowners refinancing their home 3. Abnormally low interest rates: low interest rates created an asset bubble in housing when interest rates went up, it put pressure on families who had variable rate mortgages 4. Increase in uncertainty in the economy: occurs when adverse selection and moral hazard problems are extreme lenders cannot differentiate between good and bad credit and the market for loans fails 5. Banking crisis: if a bank suffers significant loss in its loan or investment portfolio, the bank will fail if depositors become concerned, they will withdraw funds and cause a bank run bank runs are contagious due to asymmetric information the emergency economic stabilization act in 2008 aimed to help stabilize the financial system and reduce the likelihood of a run by increase deposit insurance c. The collapse of the Lehman Brothers in 2008 increase uncertainty in the financial markets and exacerbated recession interest rates shot up and trading came to a standstill d. The TARP government bailout was widely opposed but ultimately saved the economy from coming to a halt *The 2007-2009 Recession* - Global recession sparked by the 2008 financial crisis - Sharp drop in international trade, rising unemployment, and slumping commodity prices - Longest and deepest since post-world-war II *Interest Rates and Currency Values* - Example: EU investor wants to invest 1,000,000 in a US dollar denominated investment - Euro is work \$1.0966 1,000,000 EU = \$1,096,600 - APR on a three month investment is 4% so in three months the investor will receive 1,096,600 \* (1+0.04/4) = 1,107,566 - What if the exchange rate changes to \$1.1024 in three months? the EU value = 1,107,566/1.1024 = 1,004,686 EU the investor earned an APR of 1,004,686/1,000,000 -1 \*(12/3) = 1.87% which is a lot lower than the 4% APR - The decline in the value of the dollar reduced the return when converted to EU - What APR would be needed to yield 4% in euros? 1,000,000 EU \* (1+0.04/4) = 1,010,000 EU 1,010,000 EU \* \$1,1042 = \$1,115,242 \$1,096,600 \*(1+r/4) = 1,115,242 = 6.80% - Dollar investment must pay 6.80% APR in order to give EU Investor 4% APR due to depreciating dollar *Nominal vs. realized Rates* - **Nominal interest rate**: Affected by inflationary expectations in the economy - **Realized rate of return:** Rate that one actually achieves (usually differs from nominal because actual inflation is different from inflation expectations) - **1970s:** inflation was much higher than what people expected - Borrowers benefited because they paid back their loans with money that was worth less due to inflation (real interest rate was negative) repaid loans with money that was worth less than they had initially borrowed - **1980s:** inflation was much lower than what people expected - Lenders benefited because they received payments with money that had more purchasing power *\ * **Lecture 4** ============= [Topic:] Bonds/Duration/Term Structure of Interest Rates **Yield Curve Review** *Term Structure* - Relationship between yield to maturity and maturity - Describes the relationship of spot rates (YTM) with different maturities at a specific point in time for a given risk-class of debt securities (i.e., government bonds) OR - A yield curve displaying the relationship between spot rates of zero coupon securities and their term to maturity - Information on expected future short term rates can be implied from yield curve - When plotted on a graph, the line is called a yield curve *Yield Curves: Graphically* - Four yield curve shapes - Upward sloping Long-term rates \> short-term rates - Usually upward sloping - Downward sloping Short-term rates \> long-term rates - Flat Short term rates = long-term rates - Humped Medium-term rates are higher than short-term and long-term rates A diagram of upward and downward Description automatically generated *Historical Yield Curves*  *Term Structure of Interest Rates and Yield Spread* - More risky bonds will have their own yield curve and it will plot at higher YTM at every term to maturity because of the default risk that BBBs carry - The difference between the YTM on a 10 year BBB corporate bond and a 10 year government of Canada bond is called the yield spread and represents a default risk premium investors demand for investing in more risky securities - Spreads will increase when pessimism increases in the economy - Spreads will narrow during times of economic expansion (confidence) *Corporate Bond Spreads* - Corporate bond spreads tend to widen between risk classes during difficult times and narrow when the overall confidence in the economy is relatively high *Spot Rates vs. Forward Rates* - Spot interest rate: the interest rate fixed today on a loan that is made today - Forward interest rate: an estimated interest rate which is expected now for a loan that will occur at a specified future date - The actual spot interest rate that occurs in the future may (and usually does) differ - Spot and forward rates describe the relationship between short and long term rates *Demonstrating Spot and Forward Rates* A screenshot of a white background Description automatically generated A diagram of a coupon bond Description automatically generated *Forward Rate Formulas*  - The forward rate in year two the rate you would need to earn so that the future value of your investment is equal to the value it would be had you invested at a 2 year spot rate *Forward Rate Examples* A white and blue text with black text Description automatically generated with medium confidence - Can we determine what the one year spot rate is at the beginning of year 2? NO *Upward Sloping Yield Curve* A graph showing the number of values Description automatically generated with medium confidence *Downard Sloping Spot Yield Curve* A white text with black text Description automatically generated *Implications of Differences between Expected and Forward Rates* - Assume you can only invest in either a one year bond or a two year bond - Assume you have a view on where the interest rate will be in on year that is different than the rest of the market (looking into a crystal ball) - What would you do under different investment time horizon scenarios? -  - Remember the value of a bond decreases when interest rates are higher - Year two spot rate higher value of two-year bond lower when you go to sell it at the end of year one buy the one year bond - Year two spot rate lower value of two-year bond higher when you go to sell it at the end of year one buy the two year bond - INTEREST REFERS TO COUPON PAYMENT - When would you be the indifferent? when spot rate is equal to the forward rate **Theories of the Term Structure** - Three main theories are used to explain the shape of the term structure - Expectations theory - Liquidity preference theory - Market segmentation theory *Expectations theory* - If the forward rate is less than the spot rate expected over year 2, individuals who want to invest for one year would always buy a one year bond (individuals who invest in a two year bond but sell at the end of year one would earn less) - The long term spot interest rate is the average of expected future short term interest rates investors set interest rates so that the forward rate equals the spot rate expected at that time - Long term and short term securities are perfect substitutes - Forward rates that are calculated from the yield on long term securities are market consensus expected future short term rates investors set interest rates such that the forward rate over the second year is equal to the on-year spot rate expected over the second year - Investors are assumed to be risk neutral *Liquidity preference theory* - Means that the forward rate is not 100% what the market expects it will be the forward rate also needs to include a premium - In a roadshow if the tenure of the bond was short, the book would be huge more people interest in short-term bonds than long-term bonds - To sell long-term bonds, need to give a higher interest rate (higher coupon) - Long term bonds are more risky and therefore investors must be paid a liquidity premium to hold less liquid, riskier, long term debt - Yield curve has an upward bias built into the long term rates because of the risk premium - Forward rates contain a liquidity premium and are not equal to expected future short term rates - Expectations of increases in future rates can result in a rising yield curve BUT a rising yield curve does not necessarily imply expectations of higher future interest rates - Investors are assumed to be risk adverse - Yield curve: A diagram of a curve Description automatically generated with medium confidence *Theories of the Term Structure* - Market segmentation theory - Distinct markets exist for securities of different maturities (i.e., short and long term bonds are traded in distinct markets) - Ther is a limited relationship between long and short term interest rates - Trading (supple and demand) in the distinct segments determines the various rates - Observed rates are not directly influenced by expectations - Preferred habitat theory - Modification of market segmentation theory - Investors will switch out preferred maturity segments if premiums are adequate *Uncertainty and Forward Rates* - Under certainty, investors are indifferent between a short term bond and a long term bond sold before maturity, or between one long term investment and a sequence of rolled over short term investments - Under uncertainty, the strategy whose return does not depend on an unknown future bond price is less risky *What Does the Record Say?* - Yield curves are mostly upward sloping - Liquidity premiums are hard to estimate and may not be constant - Inverted yield curves generally point to declining interest rates - Steeply rising yield curves are generally interpreted as signaling impeding rate increases - To understand conditions in financial markets and seek trading opportunities - Economists use yield curves to understand and predict economic conditions - To predict future movements in interest rates (via forward rate estimation) **Basis Risk, Duration, and Convexity** *Time Travel Money Formula* A math equations and formulas Description automatically generated with medium confidence  *Coupon Bond Valuation Review* - The price of a bond is the present value of its coupon stream (an annuity) and the present value of its principal repayment (a lump sum) *Definitions of the Word "Yield"* - Current yield: measures the cash income provided by the bond as a percentage of the bond price - Does not account for capital gains or losses on bonds bough at prices other than par value - Does not account for reinvestment income on coupon payments - Coupon over the price - Yield to maturity: assumes the bond is held until maturity and that all coupon income can be reinvested at a rate equal to the yield to maturity - Measures the total return an investor would earn if they held the bond until it matures - Considers the bond's price, coupon payments, and how long it will take for the bond to mature - Used to price bonds - Realized compound yield: affected by the forecast of reinvestment rates, holding period and yield of the bond at the end of the investor's holding period - Accounts for the interest rates you are actually getting for the invested coupon payments - If interest rates are coming down, the realized yield will be less than the current yield *Growth of Invested Funds*  *Realized Yield Versus Yield to Maturity* - Reinvestment assumption - Holding period return - Changes in rates affects returns - Reinvestment of coupon payments - Change in price of the bond A close-up of a coupon Description automatically generated A screenshot of a computer Description automatically generated *Interest Rate Risk* - Two effects of discount rate changes on bond investments: - Income effect: effect of rate changes on value of reinvested cash flows rates up, reinvested value up - Wealth effect: effect of rate changes on price rates up, price down - The two effects act in opposite directions - Capital gain: interest rates go down and bond value goes up - But reinvestment rate goes down which counters the capital gain - Using the concept of duration, you can figure out what you need to do so that the two imposing implications balance each other out immunization against changes in interest rates - If interest rates go down, you make less on the reinvestment rate which decreases the HPR - Usually sell stuff before maturity *Bond Prices* - Change in bond price as a function of change in yield to maturity  - A bond's price moves inversely with its YTM increase in YTM decreases its price - Has to do with the coupon payments - i.e., Bond has face value of \$1,000 and a 5% coupon \$50 - When the bond's price decreases, you can buy it for less than its face value but the coupon payments remain the same you still get \$50 and the effective return (YTM) goes p - Bond sells at a discount YTM rises - Bond sells at a premium YTM falls *The Concept of Duration* - A measure of a bond's lifetime, stated in years, that accounts for the entire pattern (both size and timing) of the cash flows over the life of the bond - Measures how long it takes in years for an investor to be repaid a bond's price through its total cash flows - Different from a bond's term term is a linear measure of the years until repayment of its principal is due does not change with the interest rate environment - Duration is nonlinear accelerates as the time to maturity lessens - The weighted average time to maturity of a bond's cash flows weights determined by present value of cash flows - Bonds with longer durations have greater price volatility (and risk) than those with shorter durations - Bonds with longer duration are more at risk of interest rate risk and vice versa *Macaulay's Duration Formula* A math formula with numbers and symbols Description automatically generated with medium confidence - Calculates the weighted average time until all the bond's cash flows are paid - Find the present value of a bond's future coupon payments and maturity value - The greater the duration, the greater the interest rate risk or reward for bond prices - Take present value of each cash flow, divide it by the total present value of all the bond's cash flows and multiply the result by the time to maturity in years *Duration Example* - 8 year, 9% coupon bond  *Duration as a Fulcrum* A graph with pink and white bars Description automatically generated  A graph of a number of people Description automatically generated - The higher the coupon rate, the shorter the duration (all else equal) and lower the interest rate risk - The higher the yield, the shorter the duration (all else equal) *Why is Duration Important?* - Allows comparison of effective lives of bonds that differ in maturity, coupon - Used in bond management strategies, particularly immunization - Measures bond price sensitivity to interest rate movement which is very important in any bond analysis - The slop of a bond's price/yield relationship measures the bond's sensitivity to changes in yield - One can estimate how a bond's price will change using duration -- you are effectively moving along the slope of the bond price/yield curve *Properties of Duration* - Zero coupon Bond: Duration = Maturity - For coupon-paying bonds, duration \< maturity (all else being equal) - The longer the maturity, the higher the duration, and the greater the interest rate risk - The higher the coupon, the shorter the duration (all else equal) - The higher the YTM the shorter the duration for coupon bonds (all else equal) confirm that his is YTM - For bonds selling at par or above, duration increases at a decreasing rate with maturity - For bonds selling at a discount, duration increases with maturity for a long time then declines - Maturity and duration can vary substantially - Bond prices vary proportionately with duration *Duration and Price Sensitivity: "The Duration Rule"* - A bond's price change is proportional to a modified duration can approximate how a change in yield will change a bond's price using a modified definition of duration and the change in yield "Duration Rule" - Approximation is more accurate with small changes in yield  **Duration and Convexity** *Bond Price Convexity* - Duration assumes a linear relationship between bond prices and yields - The actual relationship between bond prices and yields is not linear A diagram of a price curve Description automatically generated with medium confidence - The curved line represents the actual percentage change in bond price in response to a change in the bond's YTM for a 30 year, 8% coupon bond initially selling at an 8% yield - The two lines are tangent at the initial yield indicates that the simple duration formula is accurate for small changes in a bond's yield less accurate for larger changes - The capital gain from a decrease in the discount rate exceeds the capital loss from a corresponding increase in the discount rate *Properties of Convexity* - Lower coupon, higher convexity - Lower coupons have longer durations because they maker smaller payments price changes more significantly with interest rate movement - Since majority of a bond's cash flows are received at maturity, as interest rates fall, the present value of a bond's final payment becomes more valuable which causes a larger increase in price (and vice versa) - Lower yield, higher convexity - For lower YTM bonds, small changes in interest rates have a disproportionately large effect on the price due to the smaller discount rates applied to future cash flows - Lower YTM = longer durations and longer durations = higher convexity - Longer maturity, higher convexity - Bond prices vary proportionately with convexity *Duration and Convexity of Callable Bonds*  **Using Duration to Immunize Against Interest Rate Risk** *Immunization Strategies* - Immunization: strategy used to mitigate interest rate risk - Two types of strategies: - Target date immunization: holding period matches duration (pension funds/insurance) - Net worth immunization: Duration of assets = duration of liabilities (banks) *Target Date Immunization* - Used when the investor knows that they will need their money at some point in the future - Investor strives to match the duration of the bonds with the investor's time horizon present value of bonds = present value of future need - Interest rates and bond prices move in opposite directions so investor strives to find bonds whose "interest on interest" offsets the change in a bond's price gains from reinvesting coupon payments (if rates rise) will offset the losses in bond prices - As interest rates rise, bond prices decreases, but the reinvested coupon payments can be reinvested at higher interest rates - Balance the changes in bond prices with the changes in reinvestment income so that the portfolio's overall value is stabilized against interest rate changes - Rebalancing is typically required to keep durations equal could involve selling shorter-term bonds and buying longer-term bonds to maintain the target duration *Net Worth Immunization* - Important for institutions with liabilities (i.e., banks) - Ensures net worth stays the same, regardless of interest rate changes - If bank matches the duration of their assets with their liabilities, they are immunized from interest rate movements change in interest rates will effect the value of assets and liabilities equally A white rectangular box with black text Description automatically generated - Duration of assets \< duration of liabilities - Interest rates increase: - Shorter-duration assets are less sensitive to interest rate changes value decreases by small amount when interest rates rise - Liabilities with longer duration are more sensitive to interest rate increases value decreases by larger amount - Net worth increase for investor - Shorter duration assets: Receive cash flows relatively soon PV is less affected by changes in interest rates - Longer duration assets: Receive most of their cash flows farther in the future PV of distant cash flows is more affected because discounted over longer period of time (i.e., bond with low coupon lower YTM longer duration) *Implementation Issues* - Immunization is a local strategy - Liquidity considerations - Credit and call risk - Stochastic process risk - Convexity - Inflation-linked liabilities - Regulation - Shortfalls - Risk management *Duration of Bond Portfolios* - The duration of a bond portfolio is equal to the weighted average of the durations of the bonds in the portfolio - The portfolio duration does not change linearly with time portfolio needs to be rebalanced periodically to maintain target date immunization **Bond Review** - Many Eurobonds pay annual coupons but domestic bonds pay semi-annual coupons - Size of coupon payment divide by two - Number of periods multiply by two - YTM divide by two - **YTM:** the discount rate used to value bonds IRR causes the sum of the present value of the bonds promised cash flows equal the current bond price - When solving for YTM for a semi-annual coupon, multiply the yield by two to obtain the annual YTM - As interest rates increase, the PV's decrease of cash flows decrease so the bond price decreases - If YTM = coupon rate par value - If YTM \< coupon rate premium - If YTM \> coupon rate discount - Price sensitivity increases with time to maturity - Longer bonds have greater price volatility than short bonds longer bond = longer period in which the cash flows are fixed - The capital gain from a decrease in the discount rate exceeds the capital loss from corresponding increase in the discount rate (convexity) - Prices are less sensitive to yield changes at higher coupon rates for a change in yield, prices change more when rates are low **Recap** *Properties of Duration* - The higher the coupon, the shorter the duration because more of the bond's value is returned to the investor earlier in its life and duration formula is a weighted average of when cash floes are received less sensitive to interest rate changes - The higher the discount rate, the shorter the duration because coupon payments received earlier in the bond's life are more significant than the final repayment of the principal (value of final payment is reduced) value of bond is tied to earlier cash flows which reduces duration - For bonds selling at a premium, duration increases at a decreasing rate with maturity high coupons act as a stabilizing mechanism (larger portion of bond's total value is paid out earlier) - For bonds selling at a discount, duration increases with maturity for a long time lower coupon payments bondholder relies more heavily on the repayment of the principal bond is more sensitive to interest rate changes - Even though bonds issued at a discount can have a high YTM, discount bonds typically have a low coupon rate so more of the bond's value is concentrated in the final repayment bond's sensitivity to interest rates increases - Low coupon counteracts high YTM *Properties of Convexity* - Convexity: the change in bond price in response to a change in the bond's yield to maturity - Lower coupon, higher convexity - Lower yield, higher convexity (low coupon is often related to low yield) - Longer maturity, higher convexity - Bonds with greater convexity usually cost more considered good because the greater gain in a bond's price when yields fall and lower loss when yields rise *How is bond price determined?* - Prevailing interest rates: As interest rates rise, existing bonds with lower coupon rates become less attractive prices go down - When bond prices go up YTM decreases because investors are paying more upfront and getting the same return - When bond prices go down YTM increases because investors are paying less upfront and getting the same return - Credit risk: If the bond issuer's credit risk changes, the bond price may adjust - Inflation expectations: if investor expect inflation to rise, they may demand higher yields lower bond prices **Lecture 6** ============= **Topic: Commercial Banking** ----------------------------- *Overview of the Banking Industry* - Frequent bank panics and the collapse of the nation's financial system during the great depression reduced the number of banks - Number of banks was further reduced by mergers - Fewer banks, more branches due to consolidation in the industry even though the number of banks has decreased, the number of total banking offices (i.e., branches) as increased - Many small banks, a few very large banks the majority of banks are very small - Holding companies predominate - **Top banks in the US by domestic deposits:** JP Morgan Chase, Bank of America, Wells Fargo, Citibank - TD is 10^th^ in the US *Branching and Consolidation* - The rapid growth in branches was a result of banks following their customers as they moved from cities to suburbs - Bank mergers that took place in the 1980s were the result of failed banks being acquired by healthy banks - Most mergers are the result of deregulation, improvements in technology, and the reduction in geographic restrictions *Bank Holding Company Structure in the US* - BHC structure is aligned with the flow of capital of BHCs during a financial crisis - Financial Holding Companies (FHCs) are well capitalized BHCs that can engage in the most risk activities given their well capitalized levels - Basel Capital rules have been implemented that get at the appropriate level of capital for the BHC and FHC structure use of contingent capital and hybrid debt securities **The Balance Sheet for a Commercial Bank** - Over the last decade, bank balance sheets have grown by over 50% - Assets of US commercial banks have doubled since 2010 - The principal source of funds for most banks is deposit accounts - Deposits take precedence over other sources of funds in case of bank failure *Assets* - Assets of a bank can be classified as loans or investments - Loans are the primary business of a bank and are highly personalized contracts between a borrower and a bank - Investments are standardized contracts issued by large borrowers and their purchase by a bank is an impersonal open-market transaction can be resold in the secondary market - **Cash Assets** - **Vault cash** - **Reserves at the Fed:** deposits held by banks at their district Federal Reserve Bank - **Balances at other banks:** banks hold demand deposit balances at other banks small banks can use deposits at other banks to secure correspondent services from large banks - **Cash items in process of collection** - **Fed funds sold:** banks that sell excess reserves in the fed funds market acquire assets - **Reverse repurchase agreements** - **Investments** - Provide a bank with tax benefits and diversification beyond that possible with only a loan portfolio usually more important to smaller banks - US treasury securities - Agency securities - Municipal securities - **Loans and leases** - Loans generate the bulk of a bank's profits and help attract deposits - Common types of loans: - Commercial and industrial loans - Bridge loan: supplies cash for a specific transaction with repayment coming from an identifiable cash flow - Seasonal loan: provides term financing to take care of temporary discrepancies between business revenues and expenses that are die to cycles of a business - Long-term asset loans: loans that finance the acquisition of an asset or assets - Loans to depository institutions - Real estate loans - Agricultural loans - Consumer loans - Credit cards: holder of a credit card is guaranteed a credit limit at the time the card is issued that depends on income and credit rating - Lease financing is a common financing technique for fleet assets, rolling stock, and other capital equipment - **Other assets** - Trading account assets: securities held for resale - Fixed assets: land, buildings, equipment...etc. - Intangibles: goodwill, pre-paids...etc. *Liabilities* - **Deposit liabilities** - **Transaction deposits:** - Demand deposits: checking accounts that the owner can withdraw instantly upon demand - NOW Accounts: demand deposits that pay interest - **Savings deposits:** - Savings accounts - Money market deposit accounts: federally insured accounts that pay interest - **Time deposits:** - Certificates of deposit (CDs): Bank liabilities issued in a designated amount with a fixed interest rate and maturity date (person deposits money for a specified length of time) Under \$100,000 - Negotiable certificates of deposit ("Jumbo CDs): Issued by large, well-known commercial banks with high credit standing, and are traded actively in the secondaries market \$100,000 or more - **Non-deposit Borrowed Funds** - **Fed funds purchases:** Banks buy and sell Fed Funds to adjust liquidity a bank that with more excess reserves than it needs can lend reserves to another bank that does not have its required reserves - **Repurchase agreements:** Bank sells securities and agrees to repurchase them later at a slightly higher price usually happens overnight and the price difference is the overnight interest rate way to raise short-term capital - **Trading liabilities:** liabilities because of short positions in financial instruments - **Eurodollars:** short-term deposits at foreign bank denominated in US dollars - **Banker's acceptance:** a draft issued by a company, drawn on by a bank draft promises payment of a certain sum of money to its holder at some future date - **Federal Reserve Bank Loans:** bank can borrow funds from the federal reserve bank for short period of time used to cover short-term deficiencies of reserves - **Capital accounts** - Bank capital: represents the equity or ownership funds of a bank account against which bank loan and security losses are charged - Capital stock: Direct investments into the bank in the form of common or preferred equity - Undivided profits: Accumulated earnings not paid out in dividends - Special reserve accounts: Set up to cover anticipated losses on loans and investments *Loan Pricing* - There are three important facets of loan pricing: - Bank must earn high enough interest rate to cover costs of funding the loan - Rate on the loan must be sufficient to cover admin costs associated with the loan - Rate must provide adequate compensation for the credit risk, liquidity risk, and interest rate risk - **The prime rate** - Historically a benchmark rate - Lowest loan rate posted by banks charged to the most creditworthy customers - Other borrowers were charged some spread over prime - Sometimes banks led below prime - Times have changed and fewer loans are priced using "prime" benchmarks that are currently used include: - Secured overnight financing rate (SOFR) - Treasury rates - Fed Funds rate - **Base-rate loan pricing** - Possible base rates: Prime, SOFR, Treasury, Fed Funds - Markups are made based on three adjustments: - Default risk - Term-to-maturity most loans are variable rate - Competitive factors (customer's access to alternatives) greater competition = lower loan rate  - **Non-price adjustments** - Adjustments that don't involve changing the nominal interest rate but do have an impact on the effective return for a bank - Effective return: actual profit a bank banks can be higher than the nominal rate - **Compensating balances:** Minimum average deposit balances that customers must maintain at the bank (usually non-interest bearing deposit account) usually 10% of amount of outstanding loan since the borrowers only has access to 90%, the effective rate of interest is higher than the stated nominal rate - **Risk reclassification:** can involve changing the nominal rate to compensate for higher risk or request more collateral, shorten maturities...etc. - **Additional collateral or specified collateral:** lowers the default risk - **Short maturities:** reduces the time the borrower has to repay so may lead to higher monthly payments - **Matched-funding loan pricing** - Fixed-rate loans are funded with deposits or borrowed funds of the same maturity - Allows banks to control the interest rate risk of fixed-rate loans - Example: a bank makes a one year fixed rate loan and funds the loan with a one year CD bank reduces interest rate risk - If the bank issued a one year loan and a six month CD, there would be a risk that after six months, interest rates would go up and the bank would need to pay more interest on CDs while receiving the same amount of interest payments on the loan *Analysing, Managing, and Pricing Credit Risk* - **Five Cs of Credit used to determine credit worthiness** - Credit: willingness to pay based on borrower's credit history - Capacity: cash flow (income) - Capital: wealth or new worth - Collateral: security for the loan (assets that can be liquidated if a loan is not repaid) - Conditions: economic conditions - **Credit scoring used to analyze a borrower's risk by assigning the borrower a score based on information in a credit report (note: high score = lower risk)** - Payment history - Amount owed - Length of credit history - Extent of new debt - Type of credit in use - Pros of credit scoring method: - Allows lenders to make fast loan decisions - Credit score is based on objective criteria - Cons of credit scoring method: - Impersonal - Difficult for borrowers to improve score - The are default risk premiums for identified risk categories *Fee-Based Services* - Correspondent banking: sale of bank services to other financial institutions - **Services**: Check clearing and collection, purchase of securities, foreign exchange, participation in large loans, data processing - Many small banks need large bank services - Trust services: wealth management and advisory services - Banks hold and manage assets for beneficiaries - Non-banking financial services: investments and insurance - Deregulation allows these services and clients understand they are not covered by deposit insurance - Allows banks to compete directly with mutual funds and investment banks - Insurance powers are more limited *Off Balance Sheet Banking* - Generates fee income for banks - Features of contingent assets or contingent liabilities may become balance sheet items - **Loan commitments:** agreement by a bank to lend a specific amount of money to a borrower over a given period - Bank does not lend the full amount upfront borrower draws on the loan when required - Becomes an on-balance-sheet asset only if the borrower draws on the loan - Examples: - **Line of credit:** funds can be drawn and repaid as needed - **Term loan:** lump sum dispersed upfront that must be repaid in regular installments longer than a year - **Revolving credit:** lines of credit allowing payment and re-borrowing within limit - **Letters of credit:** written promise to pay third party on client's behalf - Only becomes a liability for the bank when the terms of the purchase agreement are satisfied and the bank has to pay the seller - **Commercial letters of credit:** client buys goods and services and the bank promises to pay seller on behalf of the client - **Standby letters of credit:** bank promises to pay a third party in the event the bank's customer fails to do so seller relies on the bank's creditworthiness - **Derivatives:** forwards, futures, options, swaps - Used to hedge risks: goal of offsetting potential losses in one position by taking an opposite position in a derivative contract if an underlying asset's price moves unfavorably, the gain on the derivative can compensate for the loss - Used to speculate on the direction of changes in interest rates can use an interest rate swap if believe interest rates will change in a specific direction (swap fixed to floating rate if they believe interest rates will rise) - **Loan brokerage:** sales of loans after origination - Loan sales permit banks to invest in and diversify across a different set of loans - A bank can sell loans of a certain type and use the funds from the loan to make additional similar loans - Allows banks to avoid regulatory taxes - **Securitization:** assignment of cash flows from assets (usually loans) via securities to investors - Pools of loans are transferred to a trust and security backed by the loans are sold to investors investors receive regular payments from the borrowers who are repaying their loans - Securitization provides a source of funding loans that is less expensive than other sources securitized assets can be perceived as lower risk by investors and lead them to accept a lower return on their investment - Banks can collect underwriting fees in the securitization process *Bank Earnings* - Major source of income for commercial banks is interest on loans - Small banks' interest and fee income on loans is greater than that of large banks small banks tend to make more real estate and agricultural loans - Interest earned on investment securities is more important for small banks - Interest paid on deposits is one of the largest expense items for banks - Small banks pay more interest on deposits - Net interest margin = gross interest income -- gross interest expense - Small banks earn greater net interest income as percentage of assets than large banks - Provision for loan losses is an expense that accounts for credit quality problems in their loan portfolio - Large banks ass more to their loss reserve than small banks - Increased during 2007 as mortgage delinquencies increased - Provision tends to move in tandem with prospects of the economy - Noninterest income is a source of revenue for large banks - Noninterest margin is typically negative for banks banks pay more non interest expense than earn in noninterest income - Less negative for large banks - Noninterest revenue and expenses have declined - Small and large banks have different noninterest expenses (small banks more related to salaries) *Bank Performance* - Bank profitability can be measured through: - **Return on average assets:** net income/average total assets - Allows for the comparison of one bank with another - **Key for evaluating the quality of bank management (because management is responsible for the utilization of assets) signals how much profit bank management can generate with a given amount of assets** - **Return on average equity:** net income/average equity capital - Tells bank owners how well management has performed on their behalf - Bank are very highly leveraged Return on equity is usually higher than return on assets because debt amplifies returns on equity - ROAE is high relative to ROAA during periods when banks have high leverage (low capital to asset ratios) **HBR Article: Economics of Retail Banking** -------------------------------------------- **Customer Profitability in Retail Banking** *Customer Revenue* - **Investment income from deposit balances:** deposits generate investment income for the customer **net interest margin** = difference between the rate bank pays on deposits and rate bank makes on investing the deposits (i.e., lending market) - **Fee income:** checking accounts, late payments, overdrafts - **Loan interest and base lending rates:** loan interest is a bank's primary source of revenue *Costs* - **Interest paid on savings accounts or certificates of deposit** - **Transaction related costs** - **Allocated Fixed costs** **The Profitability Problem** - The contribution of individual customers to bank earnings varied widely a small percentage of customers cross-subsidise the profitability of the bulk of the customer base (so a small number of profitable customers help cover the cost of serving the majority of other customers) - Segmentation of a bank's customers: - **A customers:** high profit group that maintained high balances in low interest bearing accounts or paid substantial fees - **B customers:** ranged from borderline profitable to marginally unprofitable - **C customers:** destroyed the most value - Better management of customer relationships might greatly improve retail banks' profitability **Managing Customer Profitability** *Tiered Service* - Reallocate customer service resources away from low profit tiers to customers in higher profit tiers leads to increased retention of a bank's best customers - Important to note that wealth does not correlate with profitability higher income customers might maintain higher balances but their accounts can be more costly to service lower and middle income customers can be included in top tiers income is a poor predictor of customer profitability *Pricing Initiatives, Fees, and Cross-Sell Programs* - Increasing fees for basic serves can encourage customers to migrate transactions from high cost channels like branches to low cost channels like digital banking and ATMs - Can offer high profit customers fee-waivers and rate-breaks *Branch Consolidation* - Banks tried to get their customers to convert to lower cost channels like electronic banking but customers did not view alternative electronic channels as substitutes for branches - Important to note that making banking more convenient through online platforms could actually have a negative effect: could result in increased transactions that offsets the cost savings associated with the more convenient banking option *\ * **Lecture 8** ============= **Topic: International Banking** -------------------------------- *International Firms and Banks* - **International firms:** invest in a foreign currency to gain access to local markets - Firms must manage the currency risk related to: - Changes in the value of the foreign currency relative to the USD - Political risks - Environmental concerns - Cultural differences *History* - International banking dates back to the rise of international trade - Great Britain dominated international finance until after WWII - US banks historically had very little international operations because national banks were not permitted to establish branches or accept bills of exchange outside the US until 1913 - **Federal Reserve Act of 1913:** Allowed federally chartered corporations outside of the US - **The Edge Act 1919** - Allowed banks to create subsidiaries that could engage in international banking federally chartered corporations for international banking - Allowed edge corporations to make equity investments overseas - Allowed US banks to compete more effectively against stronger and better-established European banking houses - 1966: banks permitted equity investments in foreign bank stock - Growth slowed in the early 1970s - US regulations limiting the outflow of funds to foreign countries were eliminated - Smaller banks could not compete with larger international operations - International lending increased in 1974 - OEPC increased oil prices - Oil producers and importers had surplus/deficit funds to flow to invest or finance - Japanese banking dominated the world in the late 1980s - Many of the largest US banks began merging in the 1980s - There are fewer US banks, but they have larger networks of global affiliates - The decline in US banks relative to foreign competitors has slowed due to - Impact of the financial crisis - Increased international capital adequacy standards - Merger activity among the US banks *Reasons for US Banks' Global Expansion* - Increased expansion of US trade and foreign markets - Growth of multinational corporations banks followed their US customers who expanded internationally - Regulations limited capital transfers from the US banks raised funds abroad to get around these regulations - Competitive positioning - Growth opportunities *The US Regulatory Framework* - Bank Holding Company Act of 1970: regulated international activities of bank holding companies - International Banking Act of 1978: extended federal regulation to foreign banks in the US - DIMCA of 1980 gave Fed more regulatory power over foreign banks and permitted US banks to establish international banking facilities - International lending supervision act of 1983 mandated the reporting of country-specific loan exposure information by commercial banks and established standardized procedures for dealing with program loans - Foreign bank supervision enhancement act of 1991 provided the federal reserve with greater authority over foreign banks - Financial services modernization act of 1999 allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate and invest in high-risk investment - **Dodd Frank Act of 2010 significantly limited trading activities and speculative investments of insured depository institutions** - **Goal of domestic US bank regulation:** - Bank safety, financial soundness, and stability - Bank competition - Banking business is kept separate from other types of business activities *US Regulators* - The Federal Reserve and the OCC supervise activities of US banks' foreign operations - OCC: examines national banks - Fed: examines start-chartered member banks, supervises Edge Act corporations, and supervises foreign acquisitions by domestic bank holding companies - Federal deposit insurance corporation insure deposits up to \$250,000 for federally chartered foreign branches *Allowable Banking Activities* - US banks operating in foreign countries are allowed to engage in: - Security underwriting - Equity investments - US banks operating in foreign countries are not allowed to engage in: - Owning nonfinancial businesses - Control of foreign companies *Delivery of Overseas Banking Services* - Representative offices: assist parent bank customers - Shell branches: limited wholesale services rather than retail public branches - Correspondent banks: relationship with foreign banks to provide international banking services - Foreign branches: provide full banking services in foreign countries - Edge corporations: subsidiaries of US banks engaging in international activities not permitted to domestic banks - Foreign subsidiaries: owned entirely or in part by a US bank, bank holding company, or Edge Act corporation - Foreign affiliates: small ownership interest in foreign bank by US bank *International Banking Facilities (IBFs)* - Fed permitted IBFs beginning December 1981 - May be established by a US depository institution, a US branch or agency of a foreign bank, or a US office of an Edge Act corporation - Not subject to US banking regulations - Deposits can only be used to make foreign loans *Characteristics of International Loans* - **Funding** - International loans tend to be large multinational firms and sovereign countries are borrowers - Most large international loans are funded in the Eurocurrency market - Banks often lend to each other in the interbank market - **Pricing** - Rates were based on LIBOR throughout history with nonbank borrowers paying above LIBOR - LBOR ceased to be used in 2023 after it became apparent that it was vulnerable to manipulation - SOFR is now used as the base rate - **Syndicated loans** - Syndicates of banks fund large international loans - Pros: spreads risk and provides larger amount of funds to borrowers - Private equity firms can assist in the issuance of sponsored loans - Sponsorship is associated with complex transactions with syndicates, issues with more information asymmetry, and issues without covenants and lower credit ratings enable high risk firms to raise capital - Cost of loans with sponsors is higher than without since the loans tend to be riskier, they come with a higher cost - Stock price reaction to syndicated loans is positive and more pronounced for sponsored syndicated loans - **Collateral** - Most international loans are unsecured - Most business borrowers have high credit ratings *Risk in International Lending* - **Country risk:** Related to the political stability, laws, and regulations of the foreign country - Expropriate - Nationalization - Change of government - **Currency risk:** Risk of currency value changes and exchange controls **HBR Case: OJK** ----------------- *Backdrop (1980s in Indonesia)* - Bank credit ceilings and interest rate control were abolished huge increase in deposits and lending - Reserve requirements were halved - Certificates of deposit were introduced to generate liquidity - The Bank of Indonesia intervened in the FX market to maintain the value of the Rupiah if Rupiah became too weak, the bank would sell USD in exchange for Rupiah, decreasing its supply and driving up its value *Asian Financial Crisis* - Indonesia's account deficit and high short-term foreign debt left it in a vulnerable position - The Bank of Indonesia initially intervened in the FX market but was forced to float the Baht raised interest rates but struggled to stabilize the currency - Many banks failed to meet minimum reserve requirements and liquidity crisis ensued - Indonesia sought IMF assistance which led to the closure of insolvent banks - Public confidence plummeted and bank runs occurred - The rupiah lost value, GDP contracted, poverty increased *Political Issues* - Indonesia has a history of political instability - Corruption in the public sector remains a significant issue bribery to navigate legislative gridlock - The Bank of Century bailout in 2008 highlighted concerts about effectiveness of banking supervision and public trust in government institutions - OJK was created to address political issues by increasing the independence and transparency of financial supervision *The Important of Debt In Indonesia* - Banks in Asia were fueled by an inflow of short-term foreign capital during the first half of the 1990s allowed them to led to projects that needed cheap funds - Indonesia's debt was 60% of GDP during the Asian financial crisis - Debt management became critical and Indonesia turned to the IMF for assistance and began restructuring measures to stabilize the economy - To recapitalize the banking system, the state issued a ton of debt instruments to the public and bank of Indonesia creation of a government bond marker for first time in history *Pros and Cons of OJK* - **Pros** - Unified oversight regulation of banks, capital markets, and NBFIs under one authority - Consumer protection ability to launch criminal investigations - Separation of powers (reduced conflict of interest) before OJK, the Bank of Indonesia was responsible for both monetary policy and banking supervision which created conflict of interest - OJK now regulates and supervises financial institutions - Bank of Indonesia now focuses on maintaining monetary stability - **Cons** - Coordination challenges and duplication of effort the separation of OJK and the Bank of Indonesia may create inefficiencies - Political influence political appointees in the selection of OJK commissioners may get in the way of independence - Corruption OJK may not combat corruption in the country if it is not properly safeguarded against political and private sector influence **Lecture 7** ============= **Topic: Credit Analysis Basics** --------------------------------- *Credit Assessment vs. Bank Risk* - **Credit assessment:** process by which one tries to determine if a company will be able to repay its loan - **Bank risk:** process by which a bank tries to ensure that it doesn't have too much risk concentrated in one company, industry, country, credit quality, currency...etc. *Optimal Loan Candidate Characteristics* - **Strong country:** Operate in a country that is politically stable with a diversified economy and a strong credit rating - **Strong industry:** Operate in an industry which has debt-friendly characteristics - Recession proof - Low cyclicality - Low capital expenditure requirements - High barriers to entry - Strong growth - Simple story - **Moat:** The company has a strong, defensible market position in the industry - **Management:** The company has a strong management with a clear strategy with a consistent history of excellent, fiscally prudent leadership - **Strong, steady cash flows, with high margins** - **Strong balance sheet with low debt** - **Significant assets that can act as collateral** - **Diversifiable, non-core assets** *Five Cs of Credit: Discussed above...* *Credit Ratings* - Convey the risk of a firm defaulting - Often co-move with YTM and price of corporate bonds - A credit rating determines a company's debt's pricing, structure, and tenor - Getting a credit rating is a time-consuming process - Factors that determine credit ratings include: - Economic conditions - Sector issues - Financial position - Core profitability - Asset quality - Balance sheet strength - Company strategy and management - Business strength - It is difficult for a company to have a credit or debt rating higher than the country in which it is domiciled country's credit rating has significant effect on credit ratigns of companies within the country *Typical Financial Covenants on Debt* - **Leverage Ratios** - Total Debt/ EBITDA - Net Debt / EBITDA - Debt / Equity or Debt / Total Capitalization - **Coverage Ratios** - EBITDA/Interest or EBIT/Interest - EBITDA / (Interest + Principal Repayment + Lease Payment) - (EBITDA -- Capex) / Interest - **Liquidity Ratios** - Current Assets / Current Liabilities - Bank debt typically has default covenants while bonds typically have incurrence tests - **Default covenants:** ratio maintenance tests that, if failed, could put the company into default - **Incurrence tests:** if there's a covenant breach, a company cannot borrow more debt until it is no longer in breach *Average Financial Ratios by Credit Rating Categories* A table with numbers and percentages Description automatically generated - Interest coverage: EBITDA/interest - Debt/EBITDA: Debt short term + long term - Debt/Capital: Debt short term + long term Capital STD + LTD + NCI + Equity - High leverage ratio = worse credit quality - High coverage ratio = better credit quality *Typical Non-Financial Covenants* - **Cross default clause:** Default on one obligation also constitutes default on another - **Negative pledge clause (unsecured debt):** Cannot pledge collateral/access to cash flows above the debt (i.e., new debt cannot take priority over the debt with this clause) - **Positive/affirmative covenants:** covenants that ensure that a company will do certain things provide timely financial reports, meeting the normal course of business, maintain liquidity levels - **Negative covenants:** designed to ensure the company who is issuing the debt with significantly be operating under its normal course of business restricts company's ability to change strategic direction, experience a change in control, sell assets, incur debt, pay atypical dividend to shareholders **HBR Article: Credit Analysis Basics** --------------------------------------- *Credit Analysis and Financial Intermediaries* - Asymmetrical information can have important implications for how markets function - Financial intermediaries can bridge information asymmetry between market participants banks act as intermediaries between those with excess cash and those with insufficient cash - For a lender to appropriately price a loan, they need an assessment of a borrower's credit risk lenders require more return on a loan from a borrower with high credit risk (risk premium) - Five Cs used in credit-risk assessments - Character willingness to pay - Capital skin in the game (owner had a lot of his own money in the business) - Capacity (cash flow) sufficient income - Collateral assets that can be used as a secondary source of repayment - Conditions business, industry, or economy conditions *Credit Pricing in Reykjavik* - 5Cs - Conditions: industry performance is highly variable - Character: borrower was man of his word - Capital: borrower had skin in the game - Collateral: fishing boat (not good because can get lost or damaged at sea) - Capacity: good right now but can change significantly based on fishing conditions small fishing companies have tremendous volatility in operating profits - Highlighted ratios: - Interest coverage = EBITDA / Interest Expense multiple of the number of times that the interest expense was covered by operating cash flow - Debt-to-EBITDA ratio = Total Debt / EBITDA indicated how many years of annual cash flow are required to meet the debt obligations of the business - Debt to capital - ROA - Revenue volatility *Corporate Bonds* - Alternative to the loan market - Companies divide their total borrowing need into smaller, tradable financial securities - Corporate bond holders require a credit-risk analysis - The credibility of credit-risk agencies depends on their incentives to maintain strong reputations they stay in business if people believe their ratings are accurate - Ratings agencies make money through fees they charge for rating bonds - Having a rating lowers cost of borrowing - Low risk bonds are called investment grade, and high-risk bonds are called speculative grade/junk bonds - C is the lowest category bond is in default *Credit-Risk Premium* - Investors require a higher return from borrowers with greater credit risk - Bond yields increase for bonds with lower credit ratings *\ * **Lecture 9** ============= **HBR Article: Deutsche Bank Restart** -------------------------------------- *Global banking Industry* - Global economy had strong growth - The economy's performance affected bank revenues - Interested rates were drivers of revenues and profits - Low rates adversely affected spread higher rates were better for banks - When the UK withdrew from the EU, global growth slowed - Three factors aversely affected the banking industry - Regulation - A weak economy - Digitization *Germany's Banks* - Germany had more banks than any other country in Europe - Germany banks were less profitable than the rest of the global industry less pressure to focus on profit maximization - Banks focused on maximizing shareholder wellbeing rather than shareholder value - Problems facing Germany's banks - Low interest rates - Dip in economic growth - Corporate deposits and bond issuances were down - Opportunities - Corporate lending grew - Household deposits increased *Deutsche Bank's History* - An international institute from the beginning formed to facilitate international trade - Took a hit after WWII when it was forced to split up and cease international operations re-entered the international market 50 years later - Shifted to investment banking in the 1990s - Biggest bank in the world in 2007 - Dropped to the lower top 10 by 2019 *Downfall* - Acquired investment banks in the US in late 90s - **Ackerman** led an aggressive expansion into IB from 2002-2012 - Initially successful but plummeted by 2008 due to low interest rates in Europe and aggressive competition in the US - Financial crisis exposed cracks in foundation: misselling of subrime mortgages, misselling of derivatives, rigging benchmark interest rate - **Fitschen and Jain** took over from 2012-2015 - **Cryan** took over from 2015-2018 - Three turnaround plans - Stock lost half its value - Restructuring approach took too long -